Corporate Financial Hedging and the Cost of Equity Capital

Using a large panel of UK public firms, we examine the relationship between the financial risk hedging and the cost of equity capital. We hypothesize that firms utilizing financial derivative instruments reduce the stock return volatility which is priced in investors’ expectations. While financial risk hedging serves as a vehicle for firms to alleviate cash flows volatility, it also leads to economic benefits to the firm value in case of the presence of increasing asymmetric information. In addition, we hypothesize and test whether the nature of relation between financial risk hedging and cost of equity capital varies and is more negative or more ambiguous with economic shocks. Our results show that engaging in financial risk hedging enables firms to have a lower cost of capital. Consistent with the extant literature, we control for potential endogeneity problems and sample selection bias using instrumental variables and treatment effects approaches. Thus, our results are robust to a battery of sensitivity checks, including the use of multiple estimation methods and alternative proxies of cost of equity measures. Overall, our findings suggest that the value of financial hedging decisions increases during economic shocks, and if financial constraints become more severe and if cash flows volatility increases.